Long-Term Hedging Rebel Co. (a U.S. firm) has a contract with the government of Spain and will receive payments of 10,000 euros in exchange for consulting services at the end of each of the next 10 years. The annualized interest rate in the United States is 6 percent regardless of the term to maturity. The annualized interest rate for the euro is 6 percent regardless of the term to maturity. Assume that you expect the interest rates for the U.S. dollar and for the euro to be the same at any future time, regardless of the term to maturity. Assume that interest rate parity exists. Rebel considers two alternative strategies: Strategy 1: Use forward hedging one year in advance of the receivables, such that at the end of each year, it creates a new one-year forward hedge for the receivables. Strategy 2: Establish a hedge today for all future receivables (a one-year forward hedge for receivables in one year, a two-year forward hedge for receivables in two years, and so on). Assume that the euro depreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as Strategy 2? Assume that the euro appreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as strategy 2?

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 11, Problem 54QA
Textbook Problem

Long-Term Hedging Rebel Co. (a U.S. firm) has a contract with the government of Spain and will receive payments of 10,000 euros in exchange for consulting services at the end of each of the next 10 years. The annualized interest rate in the United States is 6 percent regardless of the term to maturity. The annualized interest rate for the euro is 6 percent regardless of the term to maturity. Assume that you expect the interest rates for the U.S. dollar and for the euro to be the same at any future time, regardless of the term to maturity. Assume that interest rate parity exists. Rebel considers two alternative strategies:

Strategy 1: Use forward hedging one year in advance of the receivables, such that at the end of each year, it creates a new one-year forward hedge for the receivables.

Strategy 2: Establish a hedge today for all future receivables (a one-year forward hedge for receivables in one year, a two-year forward hedge for receivables in two years, and so on).

  1. Assume that the euro depreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as Strategy 2?
  2. Assume that the euro appreciates consistently over the next 10 years. Will Strategy 1 result in higher, lower, or the same cash flows for Rebel Co. as strategy 2?

This textbook solution is under construction.

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